Volatility Lurks

The European Union is putting its money where its mouth is. Never taking the
slightest blame for euro woes, its New York employees are moving to new offices
at 666 Third Avenue. The EU's United Nations delegation will "take about 45,000
square feet .... and pay about $60 a square foot annually for 15 years...." reported Bloomberg on
December 23, 2011. Negotiations with its prospective new landlord, Tishman
Speyer Properties L.P., are nearing completion. The real estate company should
consider an anti-EU hedge at the moment the EU signs up.

Sixty Euro employees will occupy the space (per Bloomberg). This works
out to a 25-by-30 square-foot office for each. "Austerity" is imposed on the
lower 99%, but not yet in Brussels, Strasbourg, or points west.

The potential break up of the European Union is more a consideration for a
landlord holding a fifteen-year lease agreement than for the average investor.
Yet, current havoc and future bedlam are clearly underpriced in all markets.
European and U.S. mispricings will be discussed here.

The S&P 500 volatility index - the VIX - is a measurement of volatility
expectations. It has fallen 50% since the (latest) agreement to save the euro
was announced. From 30.59 on December 8, 2011, (the Eurocrats trumpeted their
fiscal union pact on December 9, 2011) the VIX fell to a 20.72 close on December
23, 2011.

Whether or not fiscal continence is the route to euro salvation does not seem
to matter. As discussed in The
Rotten Heart of Europe, the Euro establishment (Brussels, banks, and bond
markets) vectored towards that conclusion. Having done so, the implied volatility
of markets is a derivative of what negotiators accomplished on December 9th.

European Voice, a Brussels-based, English-language newspaper "maintains
an independent stance regarding the affairs of the European Union." So it
claims. It is owned by the Economist Group. This disabuses the notion of neutrality.
The Economist's heart, soul, liver, and spleen promote the European
Union over national sovereignty.

Thus, Van
Rompuy Sends European Leaders Draft of Fiscal Union Pact, published
on December 14, 2011, distills the best efforts of euro fans to promote
the fiscal union pact. We learn that Herman Van Romney, the president of
the European Council, has (on December 14) sent a draft of an inter-governmental
treaty that will seek to boost economic discipline in the eurozone. It
will enter into force once nine of the 17 eurozone member states have ratified
it. It contains tougher rules on economic discipline. [Underlined words
to be explored - FJS]

Since the purpose of the pact is to convince skeptics of the euro's stability,
Van Rompuy must be planning an early retirement. Maybe next week.

The "draft" will transmogrify into a treaty by March 2012. (This and what
follows is gathered from European Voice.) How many of the still (somewhat)
sovereign states will sign is unknown. We do know that most countries "have
shown interest." Whether any more is expected of countries is not clear: "If
a eurozone country does not ratify it, it will not be bound by the new rules." That's
the problem with the euro today.

However, an EU official told European Voice that rejection by a country
would "make life politically very uncomfortable for a non-ratifying member." Here
is the mailed fist of the lifetime bureaucrat. The EU official continued: "It
["It' seems to mean the state's sovereignty - FJS] would not be durable for
long." The second decade of the 18th, 19th, and 20th century were marked by
continental European skirmishes. Four-in-a-row looks plausible.

European Voice reports there are references in the treaty to "work
jointly towards an economic policy fostering growth through enhanced convergence
and competitiveness." Yet, these references - "remain vague." Please recall
that markets, by and large, believe the Eurocrats will prevent a euro breakdown.

"Once adopted, the treaty will force countries to run a balanced budget and
enshrine that rule in their constitutions." This is the out-to-lunch attitude
of the bureaucrat: expecting, by the beginning of March 2012, the parliaments
of nine - or is it 17? - European countries to cede their parliamentary authority
(and the opportunity to hand out vote-gathering favors) regarding respective
national budgets, at a time voters are ready to lop off parliamentary heads.

Standards to enforce fiscal discipline were ignored in 2005 when "Germany
and France helped loosen the rules when they forced through the relaxation
of the anti-debt stability pact..." (From: The Rotten Heart of Europe.)
That was during a time of relative prosperity. Actually, it was a time when
all countries could borrow and spend with abandon, the very problem that has
caused the euro's decline.

In any case, an inter-government pact is unenforceable since "the European
Commission cannot take member states to court when they breach budget rules." This
is worth $60 a square foot?

Amidst this incoherence, gold and silver wallow. The VIX rose from a fat,
dumb, and happy 17.56 on July 22, 2011 to 48.00 on August 8, 2011. It was
during that time Standard & Poor's cut the credit rating of the U.S. government
and the debt ceiling terrified the nation. Should another rating agency do
so (Fitch has been making noises) one should expect volatility. (Washington
Post headline, December 27, 2011: "Obama to Ask for Increase in Debt Ceiling")

Jim Bianco [Arborresearch.com],
president and television star at Bianco Research, explained the potential
problem in an interview with Kate Welling (Welling@Weeden).
When a country loses its AAA-rating, Basel III capital requirements and central
bank rules require banks to apply haircuts against the downgraded bonds. This
would create a problem in repo markets, among others. Borrowers in the repo
market (somewhere around $4 trillion for U.S. banks) would need to find additional
collateral. (Here is the problem of falling standards of collateral leading
to demands for more collateral, again.)

Bianco explained the potential rumpus: "Since [Moody's and Fitch] are still
at triple-A, we can pretend S&P did nothing. The next downgrade, if Moody's
or Fitch were to follow S&P's lead, would actually matter a lot....
The next one that issues a downgrade would make the U.S. a split-rated double-A-plus,
which would change some of the rules."

Sheehan serves as an advisor to investment firms and endowments. He is the
former Director of Asset Allocation Services at John Hancock Financial Services
where he set investment policy and asset allocation for institutional pension
plans. For more than a decade, Sheehan wrote the monthly "Market Outlook" and
quarterly "Market Review" for John Hancock clients.

Sheehan earned an MBA from Columbia Business School and a BS from the U.S.
Naval Academy. He is a Chartered Financial Analyst.